Wednesday, May 10, 2017

Supreme Court upholds sanctity of contracts

Two recent judgements of the Supreme Court of India may have contributed to restoring the sanctity of contracts in India's infrastructure sector, which had been seriously compromised by the spate of renegotiations across sectors.

First, the Court overturned the 2016 decision by Appellate Tribunal for Electricity (Aptel) allowing Tata Power's Coastal Gujarat Power Ltd and Adani Power to charge compensatory tariffs on consumers of their respective 4000 MW and 3960 MW thermal power plants at Mundra. Aptel had ruled that the Indonesian government's decision in 2010 to link all exports of coal only at international prices was a force majeure event under the Power Purchase Agreement (PPA) signed by the two companies with the discoms of Rajasthan, Gujarat, Haryana, and Punjab. The Supreme Court has rejected that contention and disallowed any compensatory tariff levy on the PPA agreed tariffs.

Tata Power's bid in February 2006 involved an agreement to sell 4000 MW for a 25 year period at a levellized tariff of Rs 2.26 per unit, and Adani Power's 3960 MW plant agreed to sell power to Gujarat and Haryana at Rs 2.34 per unit and Rs 2.94 per unit respectively. Tata Power claims that it will lose Rs 475 bn over the 25 year PPA through under-recoveries.

The second judgement involved the Court upholding an earlier High Court order approving the e-auction by the New Delhi Municipal Council (NDMC) of the Taj Mansingh Hotel in Delhi. It rejected the claim of Tata's Indian Hotels Co Ltd (IHCL) to right of first refusal on the auction. NDMC had entered into a 33 year lease agreement with IHCL in 1976 to run a five-star hotel. This concluded in 2011 and since then after a series of ad hoc extensions, the NDMC had decided to not renew the license and re-auction the property.

In the first case, the bid process for the Ultra Mega Power Plants (UMPP) allowed all bidders to either quote their tariffs as a fuel pass-through (payment on actuals for fuel) or at a fixed rate. Both Tata Power and Adani Power passed over the former despite firm knowledge about their coal import exposure and the possible fuel price risks. In fact, Adani Power quoted a nil tariff on the escalable fuel-risk component!

In other words, here was a textbook tender design, offering all the possible options. But the successful bidders preferred to assume the imported coal price risk and bid aggressively to win the tender. The presumption may have been that coal prices were low and likely to remain so, and more importantly perhaps, there was always the renegotiation window. From hindsight one could say that the government should have anticipated a market failure by way of irrational bidding and not offered the flat tariff option. Fuel price should have been a mandatory pass through.

While ex-post this appears an entirely reasonable argument, ex-ante (or at least immediately after the bid is finalised) it would have been criticised by both the experts and the bidders. The government should, or so the critics would have argued, make available all the options and leave it to the market and bidders to determine what is in their best commercial interest. After all these large business groups have the expertise to hedge for such risks and generate all round efficient outcomes. Further, the media, most likely at the instigation of one or some of the disgruntled bidders, would have carried the counterfactual story of the government's faulty bid design causing massive presumptive loss to the consumers by foregoing ultra-cheap tariffs that some of the bidders (there would be "reliable sources") would have offered by assuming the fuel price risk. The most likely sequence of events post-bid would have been - an RTI application (to find out who took the decision on the bid parameters) or CAG audit, consequent media leaks which gloss over the nuance and sensationalise (say, the presumptive loss figure), vigilance enquiry and CBI investigation.

There are also issues of ownership of the Indonesian mines and cross-holdings which need to be explored before the full extent of any loss or gains can be established. Has anyone examined the ownership of the Indonesian mines? After all, the bidders could have hedged for some of the price risks by assuming an ownership stake in the mines. I have blogged in detail about these issues here.

In case of the Taj Mansingh Hotel, the lease agreement did not provide for a first right of refusal and the NDMC was only exercising its rightful option. In the absence of a first right of refusal, the IHCL's financial quotes in 1976 were on the basis of a 33 year contract period. In the circumstances, it had no right to claim a first right of refusal. In fact, that IHCL claimed a first right of refusal without any such contractual provision, and the matter was litigated before the High Court and Supreme Court (instead of being dismissed at admission stage) is itself a matter of concern. I have blogged here why the concept of first right of refusal itself is questionable.

In both cases, allowing the claims would have engendered serious moral hazard and eroded the sanctity of contracts even more. Contract negotiations have been a serious problem in power and roads sectors, and are likely to surface soon in ports and solar sectors. This is a much needed reality check on the solar generation bubble. The Supreme Court's decisions have hopefully recovered some lost ground.